Despite market turbulence having a negative impact on returns, diversification is set to increase after a regulations are relaxed, says Emma Oakman

Swiss pension fund managers could be forgiven for thinking CERN switched the ‘black-hole machine' on a year early. As performance fell, led in no small part by massive sub-prime losses at local banks, many funds have been looking harder at alternatives.

With the government looking set to revise regulatory asset allocation limits to include alternatives for the first time, schemes are expected to continue increasing allocations. However, worse-than-expected hedge fund performance and the commodity market correction are clouding the decision process and increasing nervousness among some schemes.

The Pictet LPP-Indicies, often considered a benchmark of Swiss pension fund performance, showed losses of between -4.17% and -11.32% over the year to 4 September 2008, depending on risk profile.

With average allocations to Swiss equities of roughly 10%, bad news coming out of local financial markets has hit pension funds particularly hard.

On 29 June 2007, UBS and Credit Suisse accounted for 18.45% of the Swiss Performance Index, with share prices of CHF73.60 (€46.42)and CHF87.35 respectively. By 25 August 2008, their total weight had fallen to 11.5% with share prices of CHF23.4 (-68%) and CHF50.30 (-42%). Both stocks remain in the top six securities of the index basket, however.

"The sharp decline in stock prices of UBS and Credit Suisse has demonstrated the dangers of concentration risk," says Sven Ebeling, (pictured right) Mercer's head of investment consulting in Switzerland. "Having such a high exposure to a small number of similar stocks is not healthy."

Even across global equity markets, higher-than-expected correlations are highlighting the need for asset class diversification. Beamtenversicherungskasse Zürich (BVK), the Pensionskasse for civil servants in the canton of Zurich, currently has some 10% of assets in alternatives including commodities (4.8%), hedge funds (3.5%) and private equity (1.5%). Daniel Gloor, (pictured left) head of asset management at BVK, says: "We will continue to diversify geographically and across asset classes. Exposure to different return drivers is very important for reducing overall portfolio risk."

Sara Gabriel, head of investment and finance for ASCOOP, agrees. "We need an investment strategy that is not very volatile," she says. "As a result, we invested in commodities two years ago and are currently considering an allocation to hedge funds, which are attractive because of their asymmetric return characteristics."

Commodities have proved to be good diversifiers during the credit crunch and Swiss schemes have been embracing them. Public funds in particular raised allocations by 1% on average, according to the figures from Swisscanto (see chart).

Its research shows public and private schemes built up allocations to alternatives across hedge funds, commodities and private equity during 2007. But despite doubling since mid-2006, the overall allocations are still very low, Ebeling says.

To some extent, this is because of Switzerland's BVG regulations, which limit schemes' exposure to different asset classes and makes no mention of alternatives.

In order to invest outside the eligible universe laid out in BVG, schemes have to refer to Article 59, justifying the decision to exceed the limits with sound analysis proving they are in line with the general asset-liability matching requirements.

"This has put a lot of funds off, particularly public funds," says Peter Bänziger, head of asset management and institutional clients at Swisscanto.

The government is reviewing the BVG regulations and an updated version is expected to come into effect on 1 January 2009. The revised version is expected to allow for alternative investments.

Bänziger expects this will drive investment in alternatives: "If you don't have to justify exceeding regulatory limits, it becomes easier to have a more normal allocation to hedge funds and commodities."

However, disappearing hedge fund returns and the recent commodity correction could undermine the impact of looser regulations. "Some clients have postponed plans for increasing allocations after hedge funds' performance proved to be more or less a disaster," Ebeling says.

As returns across a number of alternatives fail to materialise, the impact of Article 59 is compounded and nervousness is growing. "Public funds, which have to be more transparent, have a particularly hard time," says Gloor. "It is not always easy to convince politicians of alternatives' merits, especially when performance is negative. There are also a lot more people involved in the decision-making process. It took us almost two years to implement the commodities allocation in

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